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September 15, 2009 6:49 pm
For years, the yen was the currency of choice to fund international carry trades. But is the dollar starting to take its place?
Analysts say negligible US interest rates, its quantitative easing measures and little sign that the country is set to withdraw from its ultra-loose monetary policy anytime soon leaves it in a similar position to Japan at the start of the decade.
“This puts the dollar in exactly the same position as the yen back in 2001 and makes it naturally attractive as a carry trade funding currency,” says Simon Derrick at Bank of New York Mellon. “The dollar is the new yen.”
The carry trade strategy, in which low-yielding currencies are sold to finance the purchase of riskier, higher-yielding assets, was widely used in the years prior to the eruption of the financial crisis.
The low-yielding yen, and to a lesser extent the Swiss franc, were the most widely used as funding currencies, pushing them down to multi-year lows against a raft of currencies as risk appetite was supported by an abundance of liquidity and rallying asset markets. Indeed, both currencies rallied sharply as turbulence on global markets erupted last autumn and forced investors to unwind their positions.
But rather than lose their value as asset markets have shown renewed signs of strength and risk appetite has improved in recent weeks, both the yen and the Swiss franc have rallied against the dollar.
Indeed, the dollar fell to a seven-month low of Y90.18 against the yen earlier this week and on Tuesday hit a one-year low of SFr1.0318 against the Swiss franc.
The dollar has not just been weak against the yen and Swiss franc, however. After trading in a relatively narrow range over the summer months, the dollar was pushed out of its comfort zone last week, dropping to its lowest level for a year on a trade-weighted basis as trading volumes on the world’s currency markets moved higher.
Some analysts point to a change in dynamic that has made the dollar a more attractive funding currency to explain its recent fall.
While official US interest rates, such as those in Japan and Switzerland, are moored at levels close to zero, it is the rates on offer in the interbank market that are crucial in determining the profitability of carry trade strategies.
Last month, three-month dollar Libor lending rates fell below those of the yen and last week dropped below those of the Swiss franc for the first time since November, effectively making the dollar the cheapest funding currency.
Indeed, at just 30 basis points, three-month dollar lending rates are falling towards levels that led to two waves of yen-funded carry trades that weighed on the Japanese currency between 1996 and 1998, and then between 2001 and 2008.
The usual explanation for dollar weakness over recent months has been an improvement in risk appetite.
This weighs on the dollar as emboldened investors sell the currency to fund investments in higher-yielding assets elsewhere.
But some analysts believe this fails to adequately explain the secular drop in the dollar in recent weeks.
Indeed, Mitul Kotecha at Calyon says it is not clear that there was actually much further improvement in risk appetite last week.
The S&P 500 recorded its biggest weekly gain since July and equity volatility also declined, but other indicators painted a different picture.
Gold prices registered further gains above $1,000 a troy ounce. US Treasuries saw their strongest demand in almost two years for the $12bn 30-year note auction, while the earlier 10 year note auction also saw solid demand as well as strong interest from foreign investors.
Thus it has been a shift in funding rather than increasing confidence that has weighed on the dollar.
“A likely explanation for the drop in the dollar is that it is increasingly becoming a favoured funding currency, taking over the mantle from the yen,” says Mr Kotecha.
He says this is likely to continue to put pressure on the dollar: “Ultra-low interest rates suggests that the dollar will remain under pressure for a while yet, especially as the Federal Reserve continues to highlight that US interest rates are not going to go up quickly.”
Speculative positioning data seem to back up the shift against the dollar, revealing the extent of recent deterioration in dollar sentiment.
According to figures from the Chicago Mercantile Exchange, which are often used as a proxy for hedge fund activity, aggregate bets against the dollar versus the euro, yen, Swiss franc, sterling and the Australian, New Zealand and Canadian dollars last week rose to their highest levels since July 2008, when the dollar hit a record low against the euro.
But analysts say tracking the size of the carry trade, or whether or not risk appetite has improved sufficiently for it to return as a trading strategy is notoriously tough given the opaque nature of the currency markets.
Steve Barrow at Standard Bank says the fact that high-yielding currencies have rallied for most of this year while the traditional carry trade funding currencies – the yen and the Swiss franc – have not weakened throws up one of two conclusions.
“Either the carry trade has not returned and high-yielding currencies are strong in spite of any yield attraction, or another currency has supplanted the yen and the Swiss franc as the funding currency of choice,” he says. “If this is the dollar it could imply that the greenback is in real danger.”
Mr Barrow says it is certainly possible given the dollar’s weakness, negative positioning, and the fact that short-term US interest rates are down to Swiss and yen levels that the dollar has assumed the position of the carry trade funding currency of choice.
“It’s notoriously hard to find real data to determine the size of carry trades funded out of any currency, let alone the dollar. Hence, it has to remain the subject of conjecture,” he says. “Nonetheless, we feel that it is advisable to assume that this funding switch is happening.”
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